Both the long-run Philips Curve and long-run supply curves are vertical. This reveals that monetary policies only affect nominal variables but have minimal effect on real variables such as unemployment and output. In the long-run, unemployment and output remain in their natural state regardless of the imposed monetary policies. Thus, in the long-run, only a single rate of unemployment (“natural” rate) is consistent. This concept of money neutrality implies that the rate of money supply cannot have any effect on long-term supply (McEachern, 2012). These Philips Curves and the aggregate supply curves have these implications. Indeed, the curves have similar predictions on the nature of unemployment and money supply within an economy.
Explain why the Fed can attempt to target either changes in the money supply or changes in interest rates, but not both. The Federal Reserve (Fed) is a system that controls monetary and financial systems and activity within the US. The Fed cannot target both the interest rates and money supply simultaneously. This because whenever the Fed tends to concentrates on a particular variable; it loses its control over the other. For example, if fed targets money supply, it loses its strict control of the interest rates and this can cause interest rate volatility (Bade, & Michael, 2002). Consequently, when fed targets interests rates, it loses control of MS (monetary supply) restrictions. The fed often prefers controlling interest rates to monetary supply. This is because
the approach avoids conflicts with the congress that would result from escalating interest rates. Moreover, interest rates are indicators of future economic advancements. Question 3: How does monetary policy affect aggregate demand in the short run? How does monetary policy affect aggregate demand in the long run? The fed controls the supply of money through monetary policies that include open-market operations, varying reserve requirements, and changing discount rates. Each of these affects the supply of money, which in turn affects aggregate demand. On the other hand, aggregate demand is the total demand of final goods and services that a country is willing and able to consume. Monetary policies determine liquidity or amount of money in circulation. This determines people’s disposable income and subsequent purchasing power. For example when people are uncertain about their economic future, they tend to increase their savings while they decrease their spending (McEachern, 2012). Thus, on the long run, monetary policies determine spending behaviors among the people. Consequently, the policies affect the level of investments within a country. For example, when interests rates are low people will tend to increase investment due to low borrowing costs. Question 4: Explain how an active policy differs from a passive policy. The federal government can steer the economy from different approaches. The monetary policies are an example of the approaches that the government utilizes to adjust the economy. The mode of application of either of the tactic determines whether the government utilizes an active or a passive approach. Thus, active policies are taken as a response towards an economic condition. Through active policies, the federal government responds to economic occurrences through a specific policy. In spite of being applicable, active policies are open to various difficulties due to their reliance on action and experience of the policymakers. Weaknesses of such policymakers can be